Thursday, February 9, 2012

Some income statements report interest income and interest expense separately, while others report interest expense as "net". Net refers to the fact that management has simply subtracted interest income from interest expense to come up with one figure. In other words, if a company paid $20 in interest on its bank loans, and earned $5 in interest from its savings account, the income statement would only show interest expense - net $15.

The amount of interest a company pays in relation to its revenue and earnings is tremendously important. To gauge the relation of interest to earnings, investors can calculate the interest coverage ratio.

I followed the link to Interest Coverage Ratio, also by Joshua Kennon:

The interest coverage ratio is a measure of the number of times a company could make the interest payments on its debt with its earnings before interest and taxes, also known as EBIT. The lower the interest coverage ratio, the higher the company's debt burden and the greater the possibility of bankruptcy or default.

Interest coverage is the equivalent of a person taking the combined interest expense from their mortgage, credit cards, auto and education loans, and calculating the number of times they can pay it with their annual pre-tax income.

Here's something:

General Guidelines for the Interest Coverage Ratio
As a general rule of thumb, investors should not own a stock that has an interest coverage ratio under 1.5. An interest coverage ratio below 1.0 indicates the business is having difficulties generating the cash necessary to pay its interest obligations.

Now we've got guidelines :)

Graph #1: Interest Coverage Ratio for the Federal Government

Graph #1 shows Current Receipts of the Federal Government, divided by Federal Outlays for Interest, or AFRECPT / FYOINT at FRED. The Current Receipts are in billions of dollars, and the Outlays for Interest are in millions, so I divided FYOINT by 1000 to convert to billions.

You can see on the graph a tall, sharp spike before 1945, related to wartime conditions I should think, then a drop, then near two decades of stability with an Interest Coverage Ratio around 15, or ten times the recommended guideline value.

A gradual decline begins in the late 1960s, and we see another decade or so of stability, 1985-1995, with the interest coverage ratio at about 6.0, or still four times the recommended level. Then the coverage ratio rises again and is now in the neighborhood of 12, or eight times the recommended minimum.

For what it's worth, then, if we judge by this business-world standard the Federal government's interest coverage ratio appears to be well out of any danger zone. This graph does not show the Federal debt to be the problem people think it is.

Some things cannot be said often enough. Excessive private debt is the problem.

8 comments:

Nicely done, Art. It should also be noted that the government has the ability to create money; private citizens can't.(legally.) With interest rates this low, it seems that there is plenty of room for borrowing by the government to pay down private debt. I'm afraid that if a certain vocal minority holds sway, we'll go the way of austerity and just compound the problem. As Jazz like to say: WASF

NOOT:"It should also be noted that the government has the ability to create money"

That is certainly true. And it is key to understanding why we must separate government from everybody else for "sectoral balances" and similar analysis. But...

I think the people who most need to be convinced of things that you and I agree on, are the same people who would immediately reject everything you say, as soon as you get to "the government has the ability to create money".

I think we have to find arguments that don't alienate people. (Not that I'm any good at it...)

Yeah. I have to remind myself of this all the time - at least about WAYS of arguing. (And still need to be reminded by other people, alas.)

But, if an argument, itself, alienates somebody, then the onus is on that person, not the argument, nor the arguer. In other words, don't try to craft arguments in a was that is intended to reach the unreachable.

I like to start with facts and data, and try to drill to reasonable conclusions (where, of course, it is possible to go wrong.)

But the unreachable are just as likely to deny the data as the drilling.